Managing for asymmetrical risk in EM local debt - Planning for a smoother ride

When it comes to investing in emerging market (EM) local debt, we seek to maximise potential returns from market exposure to attractive yield and income opportunities that go hand in hand with the relatively higher risks of this asset class.

Concurrently, we believe in harnessing manager skill to minimise downside potential, even at the opportunity cost of avoiding certain trades that could result in above-market returns.

A portfolio’s tracking error is an inadequate measure of volatility, because it gives equal treatment to the positive and negative differences between a portfolio and its benchmark.

We believe that locally denominated debt securities in EM expose investors to a variety of risks driven by foreign exchange, credit quality, interest rates, macroeconomic conditions, and regional politics.

This unique combination of risks, in our view, warrants special emphasis on limiting the downside potential - one that requires manager skill - while wringing value from market exposure to attractive yields and income.

Smoother ride strategy

Our proposed strategy for affording investors a smoother ride throughout EM cycles is to incorporate an element of capital loss mitigation during downturns:

• Maintaining a low tracking error and high volatility in risk-on periods, i.e. remaining within proximity to the benchmark’s volatility when we deem market conditions to be favourable.
• Maintaining a high tracking error and low volatility in risk-off periods i.e. managing the portfolio to much lower volatility than that of the benchmark when we believe market conditions deteriorate and become risky.

Multi-part framework

We propose a multi-part framework for riding out EM gyrations and achieving above-market annualised returns over the long haul: 

1. Analysis: Conduct a global macro analysis of emerging and developed markets - as well as the linkages between them - since we believe that no market or region can be viewed in complete isolation from exogenous factors that are affecting it, e.g. trade or international relations.
2. Risk budget: Determine a risk budget - the overall risk we wish to take, as well as the relative risk versus the benchmark.
3. Country-level risk: Once an overarching risk framework is established, we revert to the country level and determine appropriate levels of risk as well as the levers - interest rates, foreign exchange and/or credit - through which to invest.
4. Choosing securities: Seek to identify country-specific opportunities through one or more of these levers. Influencing our views are the risk/reward profiles they represent and security fundamentals.

Once we identify specific opportunities, we conduct bottom-up security selection that matches our top-down risk budget.

Note that, in our view, bottom-up considerations should be subservient to our overarching risk budget, and thus we make security-level adjustments until they conform to the top-down budget we determined.

Conclusion

The risk/reward nature of locally denominated debt in EM is idiosyncratic - the result of a complex interplay of multiple factors, including foreign exchange, credit quality, interest rates, macroeconomic conditions, and regional politics.

We believe investing in them requires a more nuanced view of risk management and the ways in which manager skill can be harnessed to benefit investors. 

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